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The virtual tax question

Should Blizzard pay taxes for the gold it earns by selling items to World of Warcraft players? Professor Theodore P. Seto’s analysis of the taxation of virtual assets is the first to distinguish between businesses and ordinary users. In this post, I attempt to explain and comment on his paper.

The discussion on how virtual assets are and should be treated by the taxman is becoming increasingly relevant as business based on virtual assets grows. The taxman wants to make sure that businesses involving virtual asset transactions are treated on an equal basis with other businesses. At the same time, publishers and gamers want to make sure that ordinary gameplay is not hampered by interventions from tax authorities.

There is no question that transactions where virtual assets are sold for real money are taxable in terms of income tax as well as sales tax, where applicable. But in some cases it may also be necessary to tax transactions where virtual assets are exchanged for other virtual assets, in order to ensure equal treatment and prevent loopholes. For example, under a system where only real-money trades (RMT) are taxable, a Second Life entrepreneur would have the advantage of being able to choose the timing of their taxable income (to coincide with deductions), while other businesses have to report sales during the accounting period in which they actually took place. The solution is that the Second Life entrepreneur’s virtual-to-virtual transactions should be made taxable. On the other hand, we certainly don’t want the virtual-to-virtual transactions of an EVE Online corporation or a World of Warcraft player to be subject to this rule. Where to draw the line between taxable and non-taxable transactions is the big “virtual tax question”.

I’ve previously blogged about Swedish Tax Agency’s attempts to draw the line here and here. There are also a few related papers in the VERN bibliography (Bryan Camp, Leandra Lederman). I am not a tax lawyer, but I follow the topic since it is crucially important to both virtual asset businesses as well as those who wish to have nothing to do with real-money trading.

Seto’s answer

Greg Lastowka informs us of a new working paper on the topic by Professor Seto of Loyola Law School, titled When is a Game Only a Game? The Taxation of Virtual Worlds. Seto summarises the previous discussion by Camp and Lederman and provides an increasingly nuanced answer to the virtual tax question. I think it’s a great paper and well worth a read.

Seto’s answer involves two types of distinctions. The first distinction is between users who are subject to cash method accounting rules and users who are subject to accrual method accounting rules. Very broadly speaking, this is a distinction between individuals and real corporations that participate in virtual economies.

The second distinction is Seto’s typology of “virtual worlds”, although I would extend it to say that it is a typology of online services containing virtual assets (i.e., virtual asset platforms), regardless of whether they involve avatars or any other feature associated with virtual worlds. It consists of the following types (pp. 13-14):

Platforms with non-redeemable, non-convertible currencies: e.g., Monopoly, World of Warcraft

Platforms with redeemable or convertible currencies: e.g., Second Life

Using these distinctions, Seto outlines a set of rules, which I have attempted to summarise and explain below. According to Seto, these rules represent not only where he thinks the line should be drawn, but also where U.S. tax law actually draws the line, if interpreted correctly. After presenting the rules, I follow with some of my own comments and analysis.

Tax rules for corporations

Accrual method taxpayers must […] report game credits or other items received in virtual worlds when they are earned, regardless of the type of world or game involved. This should be true even in the case of items earned in worlds with non-redeemable, non-convertible currencies[.] (p. 22)

In other words, for corporations, virtual-to-virtual transactions are taxable, regardless of the type of platform. If a Second Life entrepreneur (whose business is subject to accrual method accounting rules) has an profit in Linden Dollars at the end of the accounting year, they must pay tax on it. Any expenses, whether in Linden Dollars or U.S. dollars, can of course be deducted first. This implies that when the accounting year is over, the company balance sheet will contain assets in Linden dollars. If and when those assets are eventually converted into U.S. dollars, there is no need to pay income tax on them again.

Interestingly, this rule seems to imply that professional U.S. gold farmers must report their loot as taxable income, regardless of whether they intend to convert the loot to real money or not. I wonder if they are equally entitled to report armor repair costs as expenses.

One point that was left ambiguous to me is whether looted, crafted and self-designed items are considered taxable income immediately upon their creation, or only later if and when they are converted into virtual currency.

Tax rules for individuals

Cash method taxpayers engaging exclusively in in-world transactions in [worlds without redeemable or convertible currencies] should not be subject to federal income tax. For such taxpayers, the game is only a game. Transactions in worlds with redeemable or convertible currencies, by contrast, should be treated as generating [taxable income]. Real money trades, even by cash method taxpayers, similarly trigger changes in net worth; they therefore are and should continue to be taxable under standard tax timing rules. (p. 25)

In other words, for Type 1 platforms (non-redeemable, non-convertible currencies), Seto’s rule is that individuals need not report earnings unless and until they use real-money trading to convert them into cash. If a MMORPG or Monopoly player sells something on a RMT market, it is considered taxable income.

On Type 2 platforms (e.g., Second Life) virtual-to-virtual transactions are taxable even for ordinary individual users. If an individual has earned Linden Dollars, they must report the earnings in their tax statement. If and when the profit is realised into U.S. dollars, there is no need to pay tax on it a second time.

How bright is the line?

Do the rules outlined above settle the virtual tax question once and for all? According to Seto, “[f]or cash method tax payers, whether a world’s currency is redeemable or convertible may therefore conveniently serve as a bright-line test of how the world should be treated for tax purposes” (p. 25). This is very similar to the position taken by the Swedish Tax Agency. But the problem is this: how do you determine “whether a world’s currency is redeemable or convertible”?

Edward Castronova has argued for a regime where the legal status of virtual-to-virtual transactions is determined by the operator of the platform. If the operator wants to make a platform for economic exchange, they state this in their terms of service and accept the fact that virtual-to-virtual transactions within the platform will be taxed. If, on the other hand, the operator wants to make a game where in-game transactions are strictly not taxable, they must state in their terms of service that all real-money trading is forbidden.

But according to Seto, existing U.S. tax law takes a more practical approach. The question is “not one to be resolved by hypertechnical analysis of a world’s terms and conditions” (p. 23). Instead, Seto considers, among other things, whether a currency is “readily and routinely convertible into cash” (p. 24). This approach is understandable, since we know that in practice RMT takes place even in MMOs where rules forbid it, and the objective is to avoid tax loopholes. But it again forces us to return to the question of where to draw the line. If 20% of users regularly conduct RMT transactions, does that constitute “readily and routinely”? Does it matter what actions the operator takes to enforce the RMT ban? What if the operator permits RMT and provides a marketplace for it, but only a fraction of the users use it? What if other types of RMT are forbidden but it is permissible to purchase game time cards (GTCs) using in-game currency? These are real examples. To me, it looks like the line proposed by Seto and Swedish Tax Agency to distinguish between different types of virtual asset platforms is not quite so bright.

What about operators?

Seto’s analysis of the taxation of virtual assets is the first to distinguish between businesses and ordinary users. One more type of participant that might be interesting to consider is the operator of the platform (Seto uses the term “sponsor”). Linden Research is active in the real-money market for Linden Dollars, selling L$s for U.S. dollars. According to my reading of Seto’s rules, they would have to report as income not only their realised sales, but also the L$s they create out of thin air that can potentially be sold in the future. That’s a rather arbitrary number.

More frequently, operators are active participants in their in-game virtual-to-virtual markets. According to my reading of Seto’s rules, Blizzard (no doubt subject to accrual method accounting rules) would have to report as income any gold it “earns” by selling items to WoW players. Clearly this conclusion does not make any sense, so what is the exception that allows us to avoid it?

2 thoughts on “The virtual tax question”

1. The post notes that “professional U.S. gold farmers must report their loot as taxable income, regardless of whether they intend to convert the loot to real money or not. I wonder if they are equally entitled to report armor repair costs as expenses.” Not all U.S. businesses use the accrual method. Small businesses, in particular, may use the cash method. Where to draw the line between businesses that may use the cash method and businesses that may not is a separate policy question. But the gold farmers the post refers to would almost certainly use the cash method and would therefore be able to defer income gleaned in Type I platforms. No line is perfect. Most such gold farmers would probably take their cash out as quickly as possible. If so, they would engage in real money trades and be taxable as soon as they did.

As to the deduction of armor repair costs: Under my proposed rules, in-world expenditures would not be deductible in Type I platforms but would be deductible in worlds with redeemable or convertible currencies. When a player cashes out of a Type I platform in a real money trade, however, she typically cashes out net profits, not gross income. In effect, therefore, such expenditures reduce the taxable base even in Type I worlds.

2. The post notes that “One point that was left ambiguous to me is whether looted, crafted and self-designed items are considered taxable income immediately upon their creation, or only later if and when they are converted into virtual currency.” Under U.S. tax law, self-produced items are not taxable until sold, regardless of taxpayer’s method of accounting. As to found or stolen objects, a line is drawn between objects that are taken or harvested, like wheat or lumber, and treasure trove or stolen goods. The latter are taxable immediately, the former not until sold, again regardless of taxpayer’s method of accounting. My paper takes no position as to where or how this line might be drawn in virtual worlds, but does assume that a similar line would be used.

3. The difficult question, as the post notes, is how to determine whether a currency is convertible. (Determining whether a currency is redeemable is easy.) Here, I would urge that the possibility of unauthorized real money trades undertaken in violation of a platform’s terms of service should not make the platform’s currency convertible. Ailin Graef is unlikely to make $1 million by engaging in unauthorized real money trades undertaken in violation of her chosen platform’s terms of service. If caught, she risks losing all her in-world assets. The fact that some players violate the rules should not by itself change whether the platform is treated as a venue hospitable to genuine economic activity.

The post asks: “What if the operator permits RMT and provides a marketplace for it, but only a fraction of the users use it?” If my proposed rules are implemented, operators will have to make a choice. If they want to encourage in-world economic activity, they will continue to permit their currencies to be convertible; in-world activities will then be taxable under standard timing rules applied in-world. If they want users of their platforms not to have to worry about tax issues unless they engage in real money trades, they will forbid such trades on penalty of the forfeiture of in-world assets.

Some number of gold harvesters will continue to operate in worlds in which real money trades are prohibited. Again, no line is perfect. But such harvesters are likely to engage in real money trades sooner rather than later, and when they do they will be taxable immediately. In the meantime, I offer a principled way to distinguish between worlds to be treated as games, on the one hand, and worlds to be taxable under standard timing rules applied in-world, on the other.

4. The post asks: “What if other types of RMT are forbidden but it is permissible to purchase game time cards (GTCs) using in-game currency?” For a currency to be convertible it must be convertible into real-world currency, not merely into extended game time.

I hope the foregoing answers are responsive. The post has prompted me to think further about issues that merit considerable further thought. Many thanks.